Scandal Outbreak Leads to Corporate Boardroom Reforms
The fundamental pillars of corporate governance revolve around independent, non-biased decision making that serve the best interest of the company, though early boards lacked the legal and structural framework to uphold these principles. As numerous scandals led to rising public scrutiny, the role of the the board evolved to encompass a separation of director interests from those of upper management to prevent the reoccurrence of corporate collapses at firms such as Enron Corp., WorldCom Inc., and Global Crossing Ltd.
Post WWII Developments
The economic boom following World War II allowed corporate power to flourish, making the role of governance boards increasingly important. During this period of market growth, corporate managers were leading the reigns while board directors and investors were expected to follow. With corporate powers mushrooming out of proportion, the board of directors served more of a symbolic role than actual oversight which led to an era of scandals and financial fraud, one of the most notable being the wreck of Penn Central.
Penn Central’s collapse in the 1960s was caused by its board’s misinformation, poor monitoring of capital and its further debt propagation of $100 million in dividend approvals. The story caused a widespread backlash against inside directors and fueled the shift in board structure from the advisory to oversight model. As more firms such as LTV, Ampex and Memorex came under fire for fraud and mismanagement, recognition grew for the significance of independent directors. Reform was on the horizon.
Things began to change in the 1970s when the Securities and Exchange Commission (SEC) introduced new regulations that cracked down on the structure of boards. In 1976, the SEC pushed the New York Stock Exchange (NYSE) to require audit committees be composed of independent directors with access to accurate accounting information and outside auditors should they see fit. Other legislative reform proposals placed emphasis on shareholder representation and the distinction between management and oversight members. This era of corporate governance reforms had the collective effect of reconceptualizing the board’s purpose and composition in favor of actively informed, nonpartisan decision-making.
The Rise of Institutional Shareholders
Moving into the 80s, corporate governance focus shifts back to shareholder’s rights and deregulation that corresponded with a political rightward shift. Lawmakers and corporate advocates let corporate governance reside to align itself with the market mechanisms. During this decade, “The Deal Decade,” institutional investors bought more shares and held more than 40% of the U.S. equity markets, giving them more control to exercise hostile takeovers. The cycle of mergers and acquisitions that ensued were mainly motivated by quick returns.
Fearing takeovers, executives and legal courts turned to the idea of independent directors to decide on hostile bids and compare them against the value of the company. In a series of cases, the Delaware Supreme Court gave boards permission to adopt a “poison pill,” a corporate finance technique designed to drive away hostile bidders by imposing them with high costs. Placing the responsibility on independent directors re-enforced the oversight and judgement role of directory boards.
The value of independence continued to grow at the turn of the century, as reflected by continued tightening of standards for disqualifying relationships of directors, reinforced legal frameworks for fiduciary duty violations and equity linked compensation rewarding vigilance. Beyond this, internal structure developments led to the formation of nominating committees to shift the power of director selection away from CEOs. In 1996, the federal government further established the board independence standard through Section 162(m) of the Internal Revenue Code which appended a set of eligibility criteria that prohibited former officers of a corporation or anyone who has received compensation, either directly or indirectly, from said corporation to act as directors. These IRS regulations divorced economic interest from corporate governance and became important guiding points for future evaluations of board independence.
Post 2000 Board Refocus
As the economy continued to grow in the early 2000s, the lack of robust legal standards, and growing market conditions ripened the scene for numerous cases of fraud, such as systematic financial mis-reportings and deceitful accounting practices. One of the most severe and prevalent forms of profiteering was stock option backdating. Following a 1972 revision (APB 25) to accounting standards, companies were able to report executive incomes in the form of “at-the-money” stock options as business expenses for the purpose of increasing executive compensation while misinforming shareholders. Many companies then discovered that by backdating stock option grants, they were able to generate additional income that was both tax-deductible and held an underlying lower stock price. This resulted in widespread earning overstatements and record falsifications.
Enron Scandal Leads to Sarbanes Oxley
Enron Corporation, a major energy, utilities and natural gas company, was exposed in major case of institutionalized accounting fraud that generated a vicious cycle of insider trading and money laundering among its executives. In 2001, Enron filed for bankruptcy and emerged from it in November of 2004, reorganizing under the name Enron Creditors Recovery Corp. and continuing its streak of fiduciary failure, high risk accounting and “off-the-books” activities — all of which was facilitated by their lack of independent auditors and board members. Enron’s board was comprised of members who held financial ties with the company and inappropriate conflicts of interest that fueled the wildfire of diverting funds, overstating profits, and growing debts.
In the wake of major scandals from Enron to Worldcom, the federal government cracked down on lax corporate laws which led to Congressional hearings that focused on the responsibility of board directors in such matters. Following the hearings, the Sarbanes-Oxley (SOX) Act of 2002 was quickly developed and passed which mandated, among other things, independent board audit committees, the creation of the Public Company Accounting Oversight Board (PCAOB) to regulate auditing processes, internal control tests, and required that CEOs and CFOs to attest to their financial statements. The principal goal of SOX was upholding financial integrity, though it accomplished sweeping accounting reforms beyond this by reestablishing the expected roles of corporate boards.
SOX continues to have a profound impact on capital markets and boardrooms today. By enforcing independent audit committees, it strengthens the board’s role in overseeing management’s accounting practices to separate conflicting interests and ensure that no misreportings slip through to the public. In addition, SOX imposes harsher punishments for securities fraud by sentencing up to 25 years in prison if top management knowingly signs off on falsified reports. The company also loses credibility and investor confidence when they publish the required accounting restatement stating management’s misconduct. Finally, SOX strengthens disclosure between companies and the public by closing the loopholes for off-the-books activities.